Posted
by
kdawson
on Monday January 05, 2009 @09:06AM
from the black-swan-rising dept.

A few weeks back we discussed the perspective that the economic meltdown could be viewed as a global computer crash. In the NYTimes magazine, Joe Nocera writes in much more depth about one aspect of the over-reliance on computer models in the ongoing unpleasantness: the use of a single number to assess risk. Reader theodp writes: "Relying on Value at Risk (VaR) and other mathematical models to manage risk was a no-brainer for the Wall Street crowd, at least until it became obvious that the risks taken by the largest banks and investment firms were so excessive and foolhardy that they threatened to bring down the financial system itself. Nocera explores the age-old debate between those who assert that the best decisions are based on quantification and numbers, and those who base their decisions on more subjective degrees of belief about the uncertain future. Reliance on models created a 'false sense of security among senior managers and watchdogs,' argues Nassim Nicholas Taleb, who likens VaR to 'an air bag that works all the time, except when you have a car accident.'"

Liberal economics -- not liberal politics, quite the opposite most of the time -- explicitly derives its conclusions from three assumptions: that individuals make rational decisions, that they have access to information, and that they are free to buy/sell.

Those are pretty reasonable assumptions, and, when they hold, the conclusions tend to hold.

The difference with physics is that when physicists start saying "assuming that this body is of negligible mass and at non-relativistic speeds" they don't end their exposé with "thus we have a solution to the three body problem for three super massive black holes at 0.999 c"

Social psychology has shown repeated instances where rationality is seriously impaired. For example, social proof can make us all really stupid. And cognitive dissonance is a bitch. What do those words mean? When a million idiots do something stupid, you're very likely to think it's a very good idea, too. And the longer you've been doing something stupid without negative consequences, the less likely you are to stop.

Add to that the fact that those "investment vehicles" were designed to conceal information, specifically financial risk, and right here you have two out of three pillars of classic economic theory missing. Is it any wonder the whole thing went down?

Finally, I wonder if any free marketer / libertarian types actually read any Adam Smith. I remember reading a quizz, which unfortunately I can't find anymore, Marx vs. Smith, in which you were asked to identify whom had written what. Very hard to tell them apart in some cases.

What you appear to be trying to describe is the neo-liberal paradigm. That's not really what I'm talking about, although it is my opinion that it is complete bollocks, but that's just my opinion.My point is that you can't take liberal economic theory, keep the conclusions and expect them to hold when you've clearly removed the starting assumptions.

On top of that, what you write isn't even logical:

Or maybe, the assumptions are:

- that individuals make decisions which are more rational than if someone else makes it for them

What does "more rational" mean? Classical economic theory assumes that someone is rational in that it will buy something at a lesser price if it can, and will attempt to sell the least of something it's got (good, service, labor...) for as much money as it can. That's it. How can you be less rational?

In any case, if there is government intervention, which is I suppose what you are against, it's got nothing to do with the rational part of the argument, it has to do with the freedom part of it. And I haven't talked about this.

- that they have access to better information

Again, what does that mean? If gov't regulation forces companies to be more transparent (a la Sarbannes-Oxley), it means less freedom for the company but more information for the market as a whole. It's once more an impact on the third assumption but clearly not on the second.

That's certainly one way to look at it. However, it is often more useful to consider decisions in terms of degrees of rationality instead of a binary rational/irrational classification. From this viewpoint, the most rational decision would be the one that makes the most optimal trade, i.e. the one that minimizes present discomfort regarding one's situation. Other choices can then be sorted, subjectively, according to how far they deviate from this optimal result.

It's pretty clear what they (classical liberal economists) mean by rational, information and freedom. The definition is part of the theory.And since this is a theoretical model, it is also understood that nothing in reality fits perfectly.

When people are rational most of the time, are reasonably informed, and have some freedom to buy/sell, market will work for the greater good. That's the theory.

I'm just saying that here people weren't informed, and weren't being rational due to social proof + commitment; and that there's no need to invoke the dreaded loss of freedom to realize that the whole system couldn't work according to freemarket fundies' theories.

Access to information is never perfect -- being subject to scarcity like all other goods

Really? That's a very peculiar statement to make in this day and age, and on this particular site.

In essence, you seem to be treating freedom as an independent (even insignificant) aspect of economics, when in practice you cannot assume either rationality or optimal access to information without it.

I get it, you're a libertarian. You defend your opinions, if only just by parroting your usual lines.

Me, I'm just looking at the underlying theory. Rationality, information, freedom. Three conditions. Two of them are missing; whether the third is present or not is moot.

If Mr A gave Mr B billions of dollars of The Public's Money to play at a casino and both Mr A and Mr B got filthy rich when times were good, and when it blows up all that happens is Mr B loses his job and Mr A keeps his job by blaming Mr B or saying BS like "perfect storm/everyone was doing it".

Why then should Mr A and Mr B be doing things differently?

After all, in the following year, Mr A passes billions to Mr C who does pretty much the same thing as Mr B. And Mr B? He's hired by Mr D who wants Mr B to make him richer (just like he did for Mr A).

AFAIK, not long after LTCM blew up, its founder John Meriwether still managed to get hundreds of millions of dollars to start a hedge fund.

What I see are individuals making pretty rational decisions, those decisions sometimes just happen to be bad for a lot of other people. But why should those individuals care?

Their conscience should bother them? The last I checked the Economists leave the conscience stuff to "The Invisible Hand". People laugh at the religious, guess who really has even less of a clue on how things work? At least the religious have some idea about the "Invisible Hand" sort of stuff.

It's hilarious that you have all those people saying/writing stuff like "When Genius Failed".

That's like the sheep saying the wolves have failed just because the wolves dropped 95% of a billion sheep over a cliff, whilst "only" managing to stuff themselves to the brim with 1% of the billion sheep. I'm sure the wolves were a bit upset about the whole thing, but hey there are billions more sheep...

Yeah I see failure alright. Go figure where.

You want to reduce the risk of stuff blowing up, and how big they blow up? It has nothing to do with creating better financial models or better economic theories.

It has to do with making and enforcing rules like: if too many sheep die, we shoot and skin the wolves responsible. Simple as that.

All that transparency and regulation is worthless if at the end of the day the wolves get away.

"It has to do with making and enforcing rules like: if too many sheep die, we shoot and skin the wolves responsible. "

Or we could ask, "why exactly do we think that we need wolves to lead us at all?"

I mean, other than that's the way it's always been done, that sheep and wolves have this wonderful symbiotic relationship, that we've got respected sheep-universities turning out degrees in applied wolfhood, that we actively promote at all levels that sheep must aspire to become wolves and if they don't they've

Except the sheep and wolf analogy has an implied zero-sum notion to it. From our fairy tales and such we think of the wolves as nasty evil creatures, but seriously look at nature: they fulfill a role in the ecosystem and are simply a part of it.

They way I would answer your question is to say we are all wolves and we are all sheep, and the analogy is simply way off mark. Do you seriously think it wise to micro-manage every aspect of the entire economy according to some predefined notion of fairness? Because

The difference with physics is that when physicists start saying "assuming that this body is of negligible mass and at non-relativistic speeds" they don't end their exposé with "thus we have a solution to the three body problem for three super massive black holes at 0.999 c"

But if we could repeal the physical regulations, so the three black holes would be free to contract amongst themselves how they wish to move without being burdened by nanny physics, we would have that solution !

I disagree, accurate information is required for the market to choose the most efficient price/product.

"In the long run we're all dead" Keynes famously said; and in that case it means that, sure, if we wait long enough, people will stop trusting liars and crooks and they will be weeded out, but by that time damage will have been done, and the market will not have functioned optimally in the mean time.

Taleb appeared to be vindicated against statisticians in 2008, as he reportedly made a multi-million dollar fortune during the Financial crisis of 2007â"2008, a crisis which he attributed to the failure of statistical methods in finance [17][18]. According to Bloomberg, his Black Swan Protocol earned investors half a billion dollars. Taleb's financial success coupled with his earlier predictions have seen him catapulted to prominence. He has appeared on numerous magazine covers a

I kind of suspect that Taleb's hedge fund is still underwater for long-term investors. I've seen many articles quoting him crowing about this year's returns, often with fairly specific ranges elsewhere in the article. And yet, nowhere has anyone cited, say, 5 or 10 year returns. The obvious conclusion is that he has still done poorly overall.

I am skeptical that whatever wealth Taleb has is due to any unusually great talent -- many untalented people have gotten wealthy in the financial markets, which pay

It is. I work in a similar vein of the industry as Taleb (derivatives trading, but at a bank). he is the guy who says we are undervaluing the chance of a crash every day of every year and once in a while, he strikes it big. he is the guy who plays the same strategy every day and says "told ya so" when it finally pays off. he's not a fool, but it's a self fulfilling prophecy if you believe in a cyclical market so it's hard to put much weight behind him.

But, it's a cheap strategy to do in derivatives. You don't require much cash and since you are buying optionality, margin calls have a hard limit so it's less uncertain(to the downside) than other strategies.

But he is right about VAR. it's not something that is hard for anyone to tell you who has worked at a bank. I can remember 2 distinct times where my main job was to find out how to reduce our var without reducing our actual market risks (in order to free up risk capital so we could take bigger bets) and it will be my job again in a few days as everyone starts repositioning for the new year.

We have to do it in earnest because management always looks to the recent past to guess at your exposure to the future and generally, the models that VAR uses are far weaker than any modern pricing models or risk models because they are much harder to implement. the volatility of the last 18 months will cause/ is causing everyone's VAR to spike (even when carrying far less real risk) therefore adding to the massive de-leveraging management is requiring of everyone. this means over the next few months, one of the primary jobs of every trader will be obscuring the risks his portfolio is taking in order to take bigger risks (yeah, those incentives are still the same).

now you may call me a pariah but after working in this industry for a relatively short period of time, I've come to realize that is all there is in it. this is how business is done, how it was done, and how it will be done. As shareholders continue to keep their boards in place, we are obviously doing exactly what a majority of our shareholders expect of us and that is our overarching mandate (and yes, I am not an investor in any of the banks anymore, even my own, because I realize to be a successful banker you are paid by shareholders to screw shareholders).

Nocera explores the age-old debate between those who assert that the best decisions are based on quantification and numbers, and those who base their decisions on more subjective degrees of belief about the uncertain future.

Hmmmm. Math or "subjective degrees of belief about the uncertain future".

I've always operated on the principle that they were all lying, thieving, immoral, unethical, and greedy fucking bastards that were ready to bend you over for a nickel. Seems my supposition is being proven correct more and more each day.

Until recently, it was the smaller guys in the stock market that were getting screwed and the whole system kept the thievery down to a manageable level. Now from the largest, to smallest, they all seem to be getting destroyed, American in ruins, and the previously rich and powerful with outstretched hands at the Feds.

Of course maybe that is too cynical, but I always saw the stock market as rigged from the beginning. What do I know though?:)

You're looking at it all wrong! I mean, you may be right (that they are all lying, thieving, immoral, unethical, and greedy f'ing bastards), but there's opportunity in that!

Had you BET on that, you'd be rich right now. You can invest in the potential downfall of many securities. Which, by the way, was what many of the financial companies and hedge funds did.

And I really don't think this is a "if you can't beat them, join them" situation. It's recognition of human nature, and investing with that recognition in mind. You aren't necessarily doing anything illegal or immoral by betting on the downfall of companies. You are wisely investing.

Looking at it that way, many moral, ethical Wall-streeters may have made lots of money on the downside fluctuations in the market, and so your premise that they are *all* thieves must be incorrect.

Ah, see, that doesn't work either. When the market moves against the wrong players they'll use their political influence and get the rules changed. Many hedge funds and others who were 'correct' eventually lost out anyways, as the Fed simply prints money to fill the holes for the right people.

Fundamentally large parts of the market should be liquidated and shut down; overcapacity is rampant and consumers do not want the products in question at the prices they can be produced, the demand that seemed to be th

The ability to let me put my money into companies and products I think will be successful without making complex arrangements? Certainly, the stock market is taking on a life of its own but speculation happens with physical goods too. The alternative to publicly traded companies which implies a stock market is either privately traded companies or no trading at all, and I can't see any of those being better.

Sorry, you aren't putting your money into companies by gambling on the stock market. If you want to put money into a company you have to buy stock directly from them. Yes, there are occasions where companies do release new stock which is when money gets invested into actual production, but most of the stock market and other financial markets are zero sum speculations that serve little purpose other than to enrich those with the best insider information and skill.

You're assuming that the bet you're making when entering the stock market is "The price per share of the stock in [insert company here] will go up before I have reason to sell my shares." If that's the way you want to bet, fine - but you'd be an idiot to bet that way. You should be entering the stock market with this bet: "The combined value of change in price of the stock plus the dividends paid will be more than the value of what I paid for the stock." Note that I mentioned only value, not price. Although money has been described as "the universal symbol for value received", most currencies in use at this point are fiat currencies that have no fixed value, either in non-fiat currencies or in commodities. Therefore, what costs $1 today might cost $10 a week later. (In fact, Zimbabwe's economy has been doing this kind of thing recently.)

So, depending on how the rest of the economy changes - buying a stock at $100/share and selling it a year later at $10/share might actually be a good idea - if the stock paid out $95/share in dividends and the economy is otherwise unchanged, or if that $10 will buy more than $100 would have a year earlier.

Tell me the meaningful service the stock market provides and I'll listen, but I'm hard pressed to find the value in their service.

For the corporations, the ability to raise money for higher risk capital purchases than banks (were) willing to tolerate. For the short term investors, seemingly infinite liquidity compared to almost any other form of investment. For the long term investors, while the baby boomers are pouring money in, its a great ponzi scheme, at least until the baby boomers start pouring money out on a net basis.

Play a couple games of "railroad tycoon deluxe" or "RRT2" or whatever, and get back to us. There's a game ge

1) the stock market makes it possible to invest in companies at fractional rates, allowing capital to flow from small pools (you and me) to companies who seek investment capital. Without the stock market, only large investors could invest in companies, which would make it more difficult for enterpreneurs to raise funds.

2) The stock market provides liquidity for those investors who have new information about companies, and therefore want to get rid of their investment. The market makes it possible to sell. Again, this makes people more willing to provide investment funds, because of the existance of an exit strategy/mechanism.

This does not change the fact that most of the participants are lying thieving bastards, and that regulation is needed. That said, though, stock markets are an essential mechanism for the distribution of saved wealth to productive uses for that wealth, and are close to as important as money itself for allowing the economies of the world to function.

Standardized, regulated exchanges usually come about when a market already existed before, but it would be desirable to have a more transparent, reliable market clearinghouse. With stocks, people invented shares long before anyone opened an actual stock-exchange: you write out a contract on paper agreeing that, in return for $x, so-and-so now owns 1 share of your company, and you have a contract somewhere specifying how many total shares there are, when/if new shares can be issued, etc. It's basically what happens when you try to expand a small partnership to more than a few people and bring in investors.

Once you get enough of these fractional-ownership certificates floating around, each with slightly different rules, and disputes start arising about who owns what and what that means, the logical next step is to agree on some relatively standardized method of fractional ownership, and a central clearinghouse to trade the certificates. Which is what stock markets are.

On the other hand, moving that sort of business to stock markets also increases the number of market participants and frequency of transactions by reducing entry and transaction costs---it's impossible, for example, to "day-trade" paper stock certificates in person directly with their owners thousands of times per day. That has positive and negative effects---positive in that it increases available capital and gives retail investors more parity of access compared to large investors, and negative in that it makes the whole system more volatile and sensitive to chaotic-systems effects.

Tell me the meaningful service the stock market provides and I'll listen, but I'm hard pressed to find the value in their service.

The real service the stock market (or any other commodity or derivative market) provides is the transfer of risk. The market allows hedgers to minimize their exposure to risk by selling it to speculators who are willing to accept it in exchange for the potential returns. Every other function of the market is secondary to that.

The market is simply the most efficient method of risk transfer we have found. The only alternatives are to either not allow the transfer of risk at all, which would practically destro

After seeing the rampant fraud committed by the global financial elite, I'm very inclined to agree with you. What we need isn't just a number that quantifies risk, but also a number that quantifies trust.

I would pay for a service that tracks every person involved in business that was ever convicted, under indictment, or subject of a complaint. It should also track which firms employed them and where they are working now. It should also cover which "civil servants" were "on watch" at the time.

> After seeing the rampant fraud committed by the global financial elite, I'm very inclined to agree with you. What we need isn't just a number that quantifies risk, but also a number that quantifies trust.

Won't they just game that number, too? Once you fix the rules for any system, people will start to attack them. And, based on what I've seen in online games, they'll find a way to break them. Especially when there's real money at stake, not just virtual gold and items (though even those can be conve

>>>I've always operated on the principle that they were all lying, thieving, immoral, unethical, and greedy fucking bastards that were ready to bend you over for a nickel.>>>

We're discussing corporations and businessmen, not governments and politicians. Oh wait; they are the same thing. (shrug). Too bad there's still so many gullible citizens out there who believe corporations or governments are trustworthy. If only there was a way to make people more skeptical about the lies spillin

Or when a corporation gets a monopoly. As some will inevitably without regulation to stop them.

Odd, all the monopolies I can think of weren't opposed by regulation; they were *created* by regulation. Refresh my memory. What corporation has an unavoidable monopoly that was *not* given to it by government regulation? No, not Microsoft; Microsoft is very avoidable if you're willing.

If you flee to the Democrats, they hate corporations but love government. No good. If you flee to the Republicans, they hate government but love corporations. That's no good either. If only there were a party that hated both, since both corporations And governments are untrustworthy institutions. That's a party I could stand behind.

So what you're saying is that you want a political party that is essentially libertarian but also recognizes that rule by the current Libertarian Party would result in a tragedy [wikipedia.org]

I think one of the underlying problems was simple greed. For decades, how companies were viewed by Wall Street was their profitability. Over time, it became about growth. The problem with this slight change is growth in mature markets is hard, especially during downturns.

Take for example, Apple. Apple has made gads of money on the iPod. At some point everyone in the world will have one. Now they either have to find another market or Wall Street will punish them. It won't matter if they still make mon

I think that quote gets closer to the issue than what I've read so far in NYT Risk Mismanagement article. Or seen printed anywhere else, as yet.

What I don't hear anyone talking about as yet is that VaR and the other fancy new risk management tools failed to account for the way that their deployment would of itself change the underlying dynamics of the economies they were attempting to measure. WRT the housing bubble, for example, VaR measures gave banks the confidence to go with mortgages that they would

The problem with VAR is not the measure itself, which is assuredly useful if one understands the limitations.

The problem is that once any risk measure (that is say, 95%+ 'reliable') becomes institutionalized as the gold standard, catastrophic failure of the financial system is inevitable (at least according to the general black swan theory).

Why? Because any firm that doesn't optimize profit against the risk criteria is going to have a lower P/R, and will lose capital to firms who are more 'efficient' at inv

I don't think that the problem is a single number it is connectivity. You might think that if you have three investments with a 10% risk of losing Â£1,000,000 the chances of all three of them losing Â£1,000,000 is 0.1*0.1*0.1 = 0.001 or 0.1%. The thing is if one loses that much then the markets may lose confidence meaning the others go down too - they are not independent probabilities.

You might think that if you have three investments with a 10% risk of losing Â£1,000,000 the chances of all three of them losing Â£1,000,000 is 0.1*0.1*0.1 = 0.001 or 0.1%.

No, no-one who actually calculates and uses VaR thinks that. Anyone who has done any statistics, like all finance quants, will correctly take into account covariances. The actual problem is the interpretation of the "correct" VaR, and relying on it too heavily.

I'll give you the actual definition of VaR. If you calculate the VaR(10 day, 5%) to be $100,000, this means that there is a 5% chance that the loss on your portfolio over a 10 day period will be larger than $100,000, or that your profit will be larger than $100,000 assuming a symmetric distribution. It's when people think "Oh that's great, we can ONLY lose $100,000" when you have a problem. The actual loss could be ANY value larger than $100,000.

It's hardly a perfect statistic, since there are still many assumptions involved. However, it's still a decent estimator and it's better than making a wild guess based on gut feelings. Despite what most people currently believe, a lot of brainpower has gone into developing financial theories and some stuff is pretty damn good. The financial industry deserves some bashing, but it frustrates me when people spread incorrect information; at least complain about the right things.

While quants could accurately gauge the historical covariance of different assets in a portfolio, what they failed to take into account is that there is correlation in the tails of the distribution.

An example of this is that, back in the good old days, there was a degree of correlation between the Dow and the FTSE 100. If the FTSE 100 went up, it was a decent indicator that the Dow would also be up, but by no means a sure thing. However, during

Money is all about numbers, so quantifying "risk" in numerical terms is not only valid, but to be encouraged. You wouldn't bet on a horse if the odds were quoted as "almost impossible", "very unlikely" etc. You'd want to know what possible return you'd get for your bet and roughly what would be the chances of winning.

The problem in the financial world is one of thinking there's a single factor called "risk". In fact there are many, interlinked factors: The risk the business will go bust is one - however from that sprout a whole range of subsidiary risks: from losing all your investment to getting back 95% of it.

Similarly with mortgage risk and any other type of investment. What the financial markets need is a better understanding of the causal links between risks and to price the returns on investments accordingly.

That will be a *big* job, and one that will take years or decades to iron the bugs out of.

Nocera explores the age-old debate between those who assert that the best decisions are based on quantification and numbers, and those who base their decisions on more subjective degrees of belief about the uncertain future.

Why is anyone still making this distinction, as we now know that the only self-consistent numerical representation of risk follows directly from our subjective degrees of belief about the uncertain future? Furthermore, we have known this for over a generation... isn't it about time that the knowledge start filtering into the popular discourse?

While Bayesian methods are not always all that useful for practical problems (I use them on occasion in my work) the conceptual foundations and deeper understanding of the nature of plausible reasoning and its relation to probability theory needs to be more widely understood.

One of the big take-home messages from the Bayesian revolution is that probability theory is nothing but quantification of what we do subjectively, insofar as our subjective impressions are self-consistent, so the only people who are still debating quantitative vs subjective approaches as such are people who do not understand the question.

Beyond the style of model, the trouble in finance is the feedback nature. If a big impressive model is developed to price an asset and all of the big boys buy in and use the model, then the model DOES describe the assets price. Because everyone is making decisions based on the model.

That's all great until reality intervenes. Then you have a bubble.

That sort of model feedback has always made finance seem "iffy" to me.

How the hell can you apply any kind of probability measure to a self-aware environment like a marketplace?

Bayesian methods or any other are not going to get around the way the very measure of the risk is going to alter the market itself. You can't use physics and math to predict biologic and cultural processes, not when the processes have the same order of complexity as entire ecosystems and a capacity to learn and change that we haven't yet even begun to understand.

We know from random statistics of crashes involving cars which are supposedly equipped with airbags capable of deploying during an accident that a high percentage of all "untested airbag readiness" (UAR from here on) cars actually do have airbags. The risk of these not deploying is low.

Meanwhile, however magically, we know that car X's airbag will _not_ work in an accident. The risk in driving that car is high.

If X is also a UAR car, the risk is identical.If X is known to be defective, the risk is greater.I

Is here any roleplayer that does NOT know how using an artificial value to describe "real" problems automatically leads to some people "playing the system" instead of playing the game?

Nobody here ever had a munchkin in his troupe? A powergamer? A minmaxer? Someone who learned the rules and immediately started to look for loopholes, how to play by the rules without actually taking them serious?

Now why did anyone think this would be different when real money is involved, and thus the incentive to abuse the rules way higher?

I've started to play D&D a few times, but the groups I was in didn't seem to care about the rules at all and viewed my interest in the rules as bad... We never got past making a character, and I tried a few times.

So I'm serious when I ask: Why is that kind of person bad? Aren't they having fun within the rules? Don't the make the adventure more exciting instead of less? They take a system that is pretty predictable and stretch it to the limits.

Well, bad. It ain't bad if everyone's doing it and everyone's having fun. It is bad if some people actually want to play by the rules, for various reason (because they think the rules help making things fun for everyone, for example, or because they know the game falls apart if rules are simply ignored, unless people don't give a rat's behind about the game at all and just wanna "gank shit") or if they're not being told that the rules are out the window. Because it's kinda frustrating to try to play by the

If you don't like a game built around a lot of rules to be min-maxed, you play one of many other RPGs that stay far away from the D&D family, and are light on rules precisely to avoid this very issue.

In D&Ds case, the reason min-maxers are bad is because they turn a cooperative game into a competitive game: If your character is not tuned and theirs is, yours actions become less relevant, and eventually you don't feel like you are playing.

As for 'playing the system' of the stock market... I'm surprised nobody thought it could happen.

Guess you haven't been paying attention then. A lot of the rules of the market (for example, insider trading, mark to market accounting, bank reserves, etc) exist because of these well known impulses. When things go bad, the self-serving routinely express bewilderment, employing the "nobody thought it could happen" defense. Almost never is this statement true.

The problem is that your MinMaxers typically look for odd corner cases where multiple rules add up to more than average results. They also exploit Grey Areas where rules are under defined. This gives a decided edge to the MinMaxer over the other players, now while you're all working together a Win for one person should be a Win for the Team, it is not in fact a Win.

The MinMaxer succeeds more often, does more, enjoys more (maybe) at the expense of other players fun.

Now why did anyone think this would be different when real money is involved, and thus the incentive to abuse the rules way higher?

Perhaps because those in the "roleplayer" and "policy wonk" sets have almost no-overlap?

While I'm all for using simulations in systems work, thinking the econ crisis is similar to the time your party killed an Ancient Red Dragon and then bought Greyhawk with the loot probably isn't too helpful.

Risk models are largely irrelevant because the only risk anyone in the financial sector is really interested in minimizing is the risk that they will get fired. The way to do that is to do almost exactly the same thing as everybody else, no matter how mind blowing stupid it is. Plenty of people realized that banks etc were not nearly as sound as commonly believed years ago. Those that tried to act on this were fired long ago since they weren't making as high a ROI as those willing to invest in dodgy hedgefunds etc. Rational market my ass.

Mmm. Herd instincts for the lose. But the few financial instituitions that stood against the headwinds are now reaping the rewards. For example, in the UK LTSB is taking over HBOS, despite the fact that HBOS was nearly twice LTSB's size at the height of the boom. The rational players are doing just fine.

The way to do that is to do almost exactly the same thing as everybody else, no matter how mind blowing stupid it is. Plenty of people realized that banks etc were not nearly as sound as commonly believed years ago. Those that tried to act on this were fired long ago since they weren't making as high a ROI as those willing to invest in dodgy hedgefunds etc.

The key is not so much making a high ROI, as it was the separation of risk from transaction fees. My local bank would loan to anyone, as they immediately sold the loan and pocketed a transaction fee. They couldn't care less if any payments were made. Very few people realize how "investment"-type companies like banks turned into little more than a commissioned salesforce. And commissioned salespeople only make money on transaction volume, not long term return on investment.

Not quite. Risk models are important. However, at some point comes a very subjective view of how much is at stake with that risk. Let us call this resiliancy.

This is really what most of the western world is missing. Resiliancy.Resiliancy is an attitude more than just a number. This is really what Taleb talks about with the black swan.Before, they only knew of white swans. So if someone came up to you and made you a bet that there were only white swans, you would take it. Almost as if someone made a b

... is that it's OK to bet the farm - in reality, someone else's farm - because no matter how badly the bet goes, you'll still come out of it OK (in the long term - you might lose your job, buy hey when things pick up, you'll get another. No biggie). However, the person who does suffer is the ex. farm-owner, or vagrant as they're now known.

What we need is for the upside/downside/inside risks that all the banks are exposed to, to be made public. That way customers can decide for themselves which bunch of c

Far down in the depths of the article, the author points out that JPMorgan open-sourced their risk modeling methodology, which popularized the VaR (Value at Risk) approach used by most of the big financial firms:

What caused VaR to catapult above the risk systems being developed by JPMorgan competitors was what the firm did next: it gave VaR away. In 1993, Guldimann made risk the theme of the firm's annual client conference. Many of the clients were so impressed with the JPMorgan approach that they asked if they could purchase the underlying system. JPMorgan decided it didn't want to get into that business, but proceeded instead to form a small group, RiskMetrics, that would teach the concept to anyone who wanted to learn it, while also posting it on the Internet so that other risk experts could make suggestions to improve it. As Guldimann wrote years later, "Many wondered what the bank was trying to accomplish by giving away 'proprietary' methodologies and lots of data, but not selling any products or services." He continued, "It popularized a methodology and made it a market standard, and it enhanced the image of JPMorgan."

Objective or subjective models don't mean anything to people who only care about short-term performance. Whether the investment is good or bad in the long term doesn't matter to an investment manager who stands to get a seven figure bonus based on the current year's numbers. So what if the company fails next year? Not his problem.

That certainly had something to do with it, but there were a great deal of contributing factors, particularly depending on which effects of the credit meltdown you are concentrating on (bank insolvency, the decline in value of subprime mortgage assets, the decline in value of residential real estate, etc). For example (and this plays into your point) when primary lenders were distributing mortgage-backed securities to secondary lenders (other banks who would buy mortgages packaged together), they were able

The problem with using a single number is simple: It is easily gamed and there's lots of incentive to do so

Exactly. And one easy way to game the system is to bet that the authorities will always act to keep markets stable, which you can do by taking risks that would otherwise be stupid. In other words, traders are incentivized to leech off the taxpayer. I'm surprised the crash took so long.

Taleb is very arrogant. But he still cannot see beyond his limited perspective as a quant. He is right in arguing that the fundamental error in the model was to assume that the binomial distribution works for everything, but there also seems to have been a "conservation" error - assuming that risk scaled linearly with the axes. Any statistician with experience knows that reliance can only be placed on the outliers of a distribution when there is enough data around those outliers.

As an example, suppose that the distribution suggests the chance of losing 50 million dollars is +3 sigma for some measure. The problem is that there is a subtle effect - say panic, herd effect or some interaction of derivative models - which only becomes significant around the 3 sigma mark. The result could be that the exposure at a 4 sigma event is billions of dollars. A proper risk model would need to take this into account

My conclusion based on what I have read so far is that the physicists (in particular) involved in developing quantitative models would have benefited from a lot more exposure to real world experiment. They would then have had more of a clue about the unreliability of data away from the mean, scatter, and the importance of the fact that in physics subtle errors turn out to be signs that the model is wrong - e.g. relativistic effects only become important at a significant fraction of c.

A friend of mine is a risk assessment quant who was working at Lehman right up to the point where they declared bankruptcy. I asked him about this article the other day. He said that their models started telling them something was very wrong back in 2007. The problem was that Fuld (the CEO) refused to believe what the models were saying.

The most accurate model in the world won't help if you don't pay atention to the results it produces.

There's also apparently an issue with the classical VaR models depending on transparent pricing, which these real estate instruments lack. So some of the most troublesome assets apparently weren't in the model.

It's even worse than that. A coworker of mine used to work for a company that made models for mortgage banks. Some of the banks started balking that the models were showing something bad was happening, so they demanded the models be changed. Instead of saying no, the company responded by giving the banks "knobs" to tweak. This shut them up, but also let them lie to themselves till it was too late.

It bothers me because I've done both. Simply put, finance is seeking out risk. Upside risk with lesser downside. Engineering is building machines (of all kinds) to operate with minimal risk. No matter how much math you do, you can't convert one into the other (except by erroneously dividing by zero)!

Furthermore, engineered systems have two separate control systems: normal operating controls and independant safety controls. Never the twain shall meet, for often the normal controls exacerbate the situation and must be pre-empted by the safety controls. The more advanced the normal controls (optimization), the more advanced the safeties have to be.

None of this is present in finance. VaR may be all well and good as a normal operating measure, but does nothing in the tail which will blowup. I do not see anything as a tail safety measure institutionalized. What measures are taken are done on "gut feel".

Risk, in financial terms, is a measure of the variability of returns, i.e. the standard deviation of the returns. A well-diversified portfolio generally reduces the variability due to the individual risks of investments being uncorrelated. Harry Markowitz, the father of portfolio theory, pointed out that these quants all assumed that a basket of mortgages is highly uncorrelated and thus well diversified. However, in a broad real estate downturn, they all become very highly correlated. Therefore, if your standard deviation WAS 10%, it suddenly becomes 50% or more, which rapidly changes your VaR from a handful of millions to several billion overnight. VaR, being an oversimplification, didn't take that into account and all the big investment firms suddenly had billions of dollars at risk and billions of dollars of losses without realizing it. It's simply a matter of garbage-in, garbage-out, something my Portfolio Analysis prof drilled into our head and hopefully gets drilled into the heads of Wall Street CEOs.

The biggest problem with those creating financial instruments from home loans is that no one tested their models with systemic housing price decreases.

Economist Arnold Kling said that many years ago, Freddie Mac actually did "stress testing" of their portfolios under a 20% systemic real estate market downturn, but during the early 2000's they abandoned this technique.

CDOs did a good job of reducing the risk of early repayment and "random" defaults on mortgages. However it ended up concentrating the risk for a systemic market downturn.

Unfortunately, I am sure that some time in the future there will be another huge systemic risk that both government and the private sector will miss and we'll get hit again. The only thing we can do is keep economic freedom high in the period in-between to allow the economy to restructure (less jobs in building, more in health care, for example) in order to return to growth.

There is a guy called Steve Keen who more or less predicted the collapse using an ODE system. When he presented his findings (some time ago) he claims that the economists in the crowd thought that a 6 variable ODE was so complicated that he had to have made a mistake.

So Mr. Mathematically-savvy Man, why don't you go ahead and transform economics for the better? I'm sure there are many more "obvious" things out there to come up with.

VaR is a pretty decent risk measure on a micro scale. The real problem with it is that VaR constraints tend to make banks less diversified, introducing systemic risk. When things go sour, banks are forced to sell off similar assets, and because all of the banks tend to hold assets with similar risk, markets fluctuate all the more.

VaR is a pretty decent risk measure on a micro scale. The real problem with it is that VaR constraints tend to make banks less diversified, introducing systemic risk. When things go sour, banks are forced to sell off similar assets, and because all of the banks tend to hold assets with similar risk, markets fluctuate all the more.

Risk is really a bunch of intertwingled probability functions, which are probably infeasible to calculate. This seems remarkably similar to quantum mechanics and entanglement, so perhaps economic modelling would be a good use for quantum computers? Ignoring the intertwingling is probably about as silly as trying to use classical methods to calculate quantum interference, too...

Only to anyone who understands that temperature is an intensive thermodynamic quantity and therefore cannot be meaningfully averaged in an inhomogeneous medium such as the atmosphere. It is a bit scary to see a meaningless number continually used as the basis for a massive power grab.

Atmospheric heat content can be averaged, if we had a clue what it was, and a surrogate average temperature generated from that. As near as I can tell all global temperature records of n

I think they predict lots of other things, but that is just the only value the press is interested in reporting.

The article is not saying that all models which pick a single value are flawed. It is saying that trying to combine multiple qualitative values into one single quantitative number is flawed. Temperature is clearly defined and measurable, so that is no problem. But "risk" is an elusive concept that can't be simplified to a single number.

Now there is a lot of criticism about using wrong distributions (usually assumed Normal/Gaussian). Economists have known this for a very long time: pretty much anybody who as studied the subject knows most financial returns are not Gaussian.

That's why the capital requirements are set to 3 times VaR (10 days, 99%), of course this is only takes the "fat tails" problem into account.

To be frank, every risk manager (and regulator) has known that the VaR figures were arbitrary since the start, but you have to set the capital requirements somewhere... and that somewhere will ALWAYS be arbitrary because indeed, correlations and risk will always be dynamic...

The biggest criticism you could make to banks are not that they use VaR models (or Estimated Sh

No, the problem was reducing to a single number, you yourself say that just looking at 95% VaR (2 to 3 times occurence daily over one year) is not enough. You're right they need to consider 95% and 99% VaR, among other levels of risk tolerance...and I know many firms do and have been. I believe the bigger problem was the faulty assumptions in calculating VaR, primarily assuming a standard distribution bell curve. Many portfolios do not have symmetric profit. Also, when prices start to soar or plummet, v

FTA, and I think this really gets to the heart of the problem (it's talking about the execs and regulators that didn't really understand what the numbers they were looking at meant):

There was everyone, really, who, over time, forgot that the VaR number was only meant to describe what happened 99 percent of the time. That $50 million wasn't just the most you could lose 99 percent of the time. It was the least you could lose 1 percent of the time.

One of the problems is that some managers evaluated traders' performances by only looking at a single number. And that number covered results in 99 buckets, and left the contents of the last bucket uncounted.

It's trivial to set up a game that pays off modestly 999 times out of 1000, but that last one wipes out all of your losses tenfold. And the Value At Risk metric, by design, doesn't show that one out of a thousand loss. The trader posts the modest profit 99.9% of the time. Every work day for four yea

You'd have to provide some evidence that most foreclosures are investment properties. More likely everyone believed that they'd be able to refinance out of their ARM on their primary (read:only) house, because "home values all ways go up." When that wasn't the case you get what we see now.

There's plenty of blame to be spread around, from the builders who overbuilt saturating the market to the bankers who financed every subdivision to come along, to the home buyers who thought they wouldn't really have to